Swiss Franc Shocker

“Include me out.” So declared the late movie mogul Samuel Goldwyn in one of the malapropisms for which he is now remembered, perhaps more than for the movies he produced.

That might describe the attitude of the Swiss National Bank last week, when it abandoned its peg for the Swiss franc at 1.20 to the euro, which had prevailed since 2011 and just days earlier had been pronounced a “cornerstone” of its policy by the bank’s vice president. To recall a phrase from the Watergate era of four decades ago, that statement was no longer operative by Thursday, when the Swiss monetary authorities shocked the world’s markets by untethering the exchange rate, which sent the franc soaring.

About which it may be reasonably asked, why did it happen? And more to the point, why should anybody care about the monetary machinations of those gnomes of Zurich, as then-President Nixon was wont to call them back when the dollar was about to be unmoored from its fixed value in the early 1970s.

As to the first question, SNB President Thomas Jordan said the policy was no longer “sustainable,” as it required constant intervention, buying euros by the billions to maintain the exchange rate with freshly printed Swiss francs. In the process, the central bank’s balance sheet effectively quintupled in size. While the Federal Reserve inflated its balance sheet on a comparable scale, the Swiss became concerned about the side effects, including a property bubble pumped up by cheap money.

And it seemed probable that the SNB would have to step up its printing of francs even more if the European Central Bank launched its own Fed-style securities purchases, dubbed quantitative easing in polite circles. A day before the Swiss move, the European Court of Justice decided it shouldn’t stand in the way of the ECB’s options because the court lacked expertise in monetary policy. That makes it highly likely the ECB this Thursday will announce a QE program, putting further downward pressure on the euro. Had the Swiss not changed their policy, the ECB’s monetary expansion would force them to go along.

It’s said the Supreme Court reads the election returns, and the ostensibly independent Fed likely does likewise. It’s unlikely the Swiss are very different. “Much of the Swiss population is viscerally attached to the notion of a ‘healthy’ currency that is secure from perceived debasement risks; even though the recent gold referendum was rejected by 78% of voters, the fact that it occurred at all is telling of the national mood,” according to Gavekal Dragonomics. The “move on the peg indicates that the SNB has deep concerns about continuing to manipulate exchange rates and increase a balance sheet already worth 80% of [gross domestic product.]”

But as the cap was lifted and the currency soared, Swiss stocks plunged in franc terms. The export-dependent Swiss market suffered its worst week since Oct. 10, 2008, in the midst of the global financial crisis, losing some 13.3%. But in dollar terms, the
iShares MSCI Switzerland Capped
exchange-traded fund (ticker: EWL) gained 3.2% on the week, reflecting the appreciation of the franc.

The real question is why a move by Switzerland could have such an outsize impact on the rest of the world. The answer is that the rest of the world used the franc, exploiting it by borrowing the currency at ultralow interest rates, certain in the promise that its exchange rate versus the euro would be cemented.

From Russian oligarchs financing their chalets in the Swiss Alps to average Eastern Europeans who took out mortgages in francs, they sought to take advantage of ultralow interest rates. So, too, did speculators, ranging from small punters to hedge funds, that engaged in the so-called carry trade, borrowing cheaply in francs to invest in other, higher-yielding assets—a seemingly riskless maneuver, given the Swiss pledge to keep the franc from rising.

Borrowing a currency means you’ve effectively sold it short. So, when the SNB ended its peg and the franc soared, those shorts got squeezed—hard. While the peg was in place, a euro would buy 1.2 francs; if you borrowed one million francs, your debt in euros totaled €833,333. Once the peg was lifted, the franc was basically at parity with the euro, so that one million franc loan totaled €1 million—a 20% increase in an instant. (Last year, Hungary’s government presciently forced banks to convert 3.3 trillion forint ($12 billion) worth of foreign-currency mortgages into the local currency, thus sparing that nation a 700 billion forint jump in household debt, Bloomberg reported.)

And if that loan represents leverage of 50 times the underlying investment—not uncommon for currency players—those speculators are more than wiped out. In fact, the brokers who lent them the money to play were suffering, most notably
FXCM
(FXCM), a retail currency outfit, whose stock tumbled more than 90% Friday before being halted amid reports that
Leucadia National’s
(LUK) Jefferies Group was reported to have provided an investment lifeline in the form of a $300 million note with an initial coupon of 10%, according to The Wall Street Journal.

(Curiously, FXCM’s shares were down 11% Wednesday—the day before the Swiss National Bank’s shock announcement—on four times the average volume. To paraphrase another Watergate-era saying: What did somebody know and when did they know it?)

Meanwhile, the Journal reported Friday that
Deutsche Bank
(DB) and
Citigroup
(C) suffered hits of about $150 million apiece as a result of the move by the Swiss. That’s only added to the recent travails of financial stocks, which have been pronounced underperformers during the market’s recent rockiness. Indeed, the
Financial Select Sector SPDR
ETF (XLF) is down 3.1% in the past month, even a bit worse than the 2.4% drop in the
Energy Select Sector SPDR
(XLE) following the tumble in oil prices. During that span, the S&P 500 is up a scant 0.3% amid volatile day-to-day swings.

THE PROBLEM FACING THE banks is reflected in interest rates. To penalize those who would pile into the Swiss franc, the SNB lowered its negative interest rate on money that banks deposit with it to minus 0.75% from minus 0.25%. Negative interest rates no longer are rare among short-to-intermediate-term European sovereign bonds, with 10-year Swiss notes touching zero at one point.

So, according to Tradeweb’s data, benchmark German Bunds ended the week at a record low of 0.411% while France’s counterpart closed at 0.635%. Meanwhile, Spain’s 10-year finished at 1.5%, and Italy’s at 1.659%. And that’s ahead of this week’s European Central Bank meeting, at which pundits are expecting the purchase of an additional €500 billion of euro-zone government bonds—which ostensibly would drive those yields even lower.

By that standard, the U.S. Treasury 10-year, which briefly dipped to 1.75% last week before winding up Friday at 1.83%, looks like a high-yield market. And that’s in the world’s reserve currency, which is in a bull market, and comes from a government with rather stronger credit quality than those of Southern Europe. Indeed, Bank of America Merrill Lynch analysts estimate that perhaps $35 billion of the amount that the ECB pumps into the market could find its way into U.S. bonds.

But the parlous performance of bank stocks is testament to the squeeze being exerted on their net-interest margins as the eventual liftoff in interest rates is deferred farther into the future. While the consensus among Fed watchers remains that the initial hike in its federal-funds target will take place around midyear, the Chicago Mercantile Exchange’s Fed Watch site shows that fed-funds futures don’t foresee a rate increase to 0.5% or above until October.

The slide in oil and interest rates haven’t provided the kicks to the economy seen in past cycles from such events. Despite all the talk of the “tax cut” from lower prices at the pump, December retail sales fell 0.9%. Even after culling the effects of gasoline, autos, building materials, and food services, these so-called core sales were off 0.4%.

Meanwhile, the stocks of home builders
KB Home
(KBH) and
Lennar
(LEN) took hits on indications of tightening margins, which would seem out of line with near-record-low mortgage rates.

The impact of petroleum’s slide also is apparent in the 15% drop in
Baker Hughes
’ (BHI) count of drilling rigs since its peak last October. And
Schlumberger
(SLB) announced that it would lay off some 9,000 employees. In that vein, the Lindsey Group’s lynx-eyed Peter Boockvar noted that jobless claims began to pop up in Texas, totaling some 5,422 in the week ended Dec. 27.

With interest rates already at zero—and below, in some cases—central banks are running out of ammunition, especially in terms of interest rates. That hasn’t set off a stampede into stocks and out of bonds; quite the opposite.

Meanwhile, astute stockpicker Meryl Witmer of Eagle Value Partners last week told the Barron’s Roundtable that she is having trouble finding bargains worth buying. That’s perhaps the best, or most worrisome, market indicator.

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